Lecture 9(i) Announcements. Effects. oe with. and

Transcription

1 Lecture 9(i) Announcements Work on Consumer Theory worksheet (at week 9 on Moodle) before recitation. Midterm coming up. Can start looking at practice midterms (at week on Moodle). Lecture. Effects of Price Chan ge Substitution and Income Effects. Robinson and Cruso oe with indifference curves and budget constraints. (We finish the masterpiece.) Our version of 3. Start costss

2 On Friday, figured out income effect: Initially at Income = 4 (price of beer = $, price of pizza $4 Then Goldy buys: If income is $4, then B9 e8 7 e r U=3 U= Next: what happens when price changes?

3 . Income and Substitution Effects At optimum two conditions: () P pizza MRS = P beer () On budget constraint If initially at optimum and price of pizza falls, then both conditions are messed up. Breaking things down into income and substitution effects, we fix things one at a time. () Fix MRS=price ratio condition () Shift to fix budget constraint. Definitions:. Substitution effect. Effect of change in opportunity cost (by spending power held fixed so stay on same indifference curve) buy more if price falls. Income effect The effect of change in income holding opportunity cost fixed at the new level. direction of effect depends upon whether normal or inferior Let s start with the total effect. That should be easy

4 I = $4 and P Beer =$ fixed Our old graph of demand durve from the beginning of the semester P Pizza = $4: Label OCB A P Pizza = $: Label OCB C P pizza Q pizza Start at price equal $4, lower price to $, is a movement along demand B8 e 7 5 e r Pizza

5 (OCB is Optimal Consumption Bundle) Movement A to C is total effect of price decrease Breakdown into substitution effect: New opportunity cost, but original indifference curve. Label this S Substitution Effect is movement from A to S Income Effect is movement from S to C When price falls: Substitution effect: buy more (because opportunity cost is lower) Income effect (since original bundle is cheaper than before so have income left over) normal good: buy more inferior good: buy less So if normal, Sub and Inc work same way If inferior, Sub and Inc go different ways.

6 5 3 9 B 8 e 7 e 5 r 4 3 A C Pizza Example P pizza falls from $4 to $ P beer =$, Income=$ B 8 e 7 e 5 r 4 3 A C Pizza Example P pizza falls from $4 to $ $ P beer =$, Income=$4 Optimum goes from A to C (3 pizza to pizza) To get Sub Effect we rotate on original indifference condition to get MRS condition fixed B 8 e 7 e 5 r 4 3 A S C Pizza Example P pizza falls from $4 to $ P beer =$, Income=$4 Optimum goes from A to C (3 pizza to pizza) Sub effect is A to S B 8 e 7 e 5 r 4 3 A S C Pizza Example P pizza falls from $4 to $ P beer =$, Income=$4 Optimum goes from A to C (3 pizza to pizza) Sub effect is A to S Inc is S to C Normal good, both work in same direction.

7 Let s redo this maneuver, so you can get the hang of it. One of the most important applications of theory of income and substitution effects is Labor supply For consumer goods, price goes up, result in a decrease in income. So for normal goods, Sub and Inc go the same way. For labor, price goes up, individual gets an increase in income. Income Effect Leisure a normal good So income effect: work less Evidence that leisure a normal good: What do lottery winners do? Quit working?

8 Leisure: a good. Has an opportunity cost: wage. Wage goes up: Substitution effect Opportunity cost of leisure increases consume less leisure or work more What is net effect? Over time, as income has increased time spent working has gone down (but income has increased dramatically)so for trend over time, income effect has predominated B8 e7 e5 4 3 Finally let s test your knowledge of the substitution effec ct, by figuring out what it will be for Bucky who consumes in fixed proportions. Suppose pizza falls to $ P izza 3

9 Next we use our new knowledge about preferences and indifference curves to finish our diagram of comparative advantage as a basis for trade.

10 Comparative Advantage as a Basis Robinson PPF for Trade (Complete Picture!) Friday PPF 4 C o c u n u t s IC (autarky) slope=, world price IC (trade) C A PPF BC Fish B 4 C o c u n u t s Y X PPF slope=, world price IC (trade) Z IC (autarky) BC Fish Produce Consume Autarky A(F,4C) A (F,4C) Trade B(4F,C) C(F,C) Produce Consume Autarky X(4F,C) X(4F,C) Trade Y(F,4C) Z(F,C)

11 Lots of great stuff on graph!!!!. Production Possibility Frontier. Choice under autarky (pink PPF is budget constraint, choice A where MRS equals opportunity cost) 3. With trade specializing in terms of comparative advantage. Picks production B to maximize income. 4. With trade and new budget constaint in blue. Picks C to maximize utility. 5. Supply=Demand (Robinson supplies fish and Friday demands fish) 3. Costs Costs pretty simple so far in Econland S: can make or widget. Cost to make widget: $ Cost to make widget: $ In real world, things are usually more complicated.

12 Meet S Details of her widget operation. Fixed Cost of $4 to be in business These are costs that are the same regardless of quantity produced. Examples: Salary of the CEO Electric bill for lights rent on factory Q L hours (Cost in $) Labor Cost (wage= $ hr) Materials Cost Variable Cost Variable Input: Labor ($ an hour) Widget Juice ($ quart, need one quart per widget

13 The cost structure for S exhibits Diminishing Marginal Returns To get first widget, need half hour of labor To get second widget, need.5 hours of labor more. So return on additional units of labor added is diminishing. This is what happens when pick the low hanging fruit first. (Note, here we don t have diminishing returns in materials)

14 Q FC Fixed Cost One big table VC Variable Cost TC Total Cost TC = FC + VC AFC = Average Fixed Cost = FC/Q AVC = Average Variable Cost = VC/Q AFC AVC ATC MC Marginal Cost MC between and is = - 4 MC between and is 4 = MC between and 3 is = Marginal Cost: change in cost from increasing output one unit.

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